The era of Wall Street and the “investment banking model”, as we know it, is over. Warren Buffett’s expression—financial “weapons of mass destruction”—is increasingly being used to describe credit default swaps and, more generally, financial derivatives. However, the backlash against the Anglo-Saxon system of sweeping financial deregulation is leading to some unwarranted conclusions.
To clarify matters, I am not a fan of the Anglo-Saxon model of full deregulation with securitization. With regard to India, I have criticized the Percy Mistry and Raghuram Rajan committees’ advocacy of full liberalization of our banking and financial system in several recent Mint articles.
However, it does not follow that just stricter regulation and banning derivatives will ensure the avoidance of severe financial meltdowns and huge swings in the economy. Knee-jerk reactions to the current crisis are diverting attention from a fundamental fact: Sound monetary policies can foster macroeconomic stability.
Solid evidence to support this view comes from the Japanese boom of the 1980s followed by the prolonged 1990s bust, or depression. Japan was undergoing a prolonged boom during the 1980s, as its increasingly superior electronics and automobile exports were capturing world markets. GDP growth during 1986-89 was very rapid, while inflation was inching up. This was accompanied by a massive financial boom, and enormous bank lending, reflected in both soaring equity and land prices. Books and courses on Japanese management became the rage in business schools all over the world.
Yet, during the 1990s and into this decade, Japan has been the worst performing economy in the developed world. The Nikkei, which peaked at close to 39,000 at the end of 1989, reached a low of about 7,600 in April 2003. Massive fiscal stimulus and the repeatedly lowering of interest rates, down to zero, did not help. After averaging 4% during the 1980s, GDP growth was 1% during the 1990s.
What caused such a sharp decline? At a most basic level, business cycles are endemic to capitalism. They have been occurring for at least 200 years, and are partly linked to technical progress. What macro and monetary policy can, at best, do is to minimize the fluctuations, not eliminate them.
For Japan, there is clear evidence that the asset market collapse from late 1989 and its spillover to the real economy stemmed from a prior “easy money” policy. Following the Louvre agreement of February 1987, the US and Japan had agreed to coordinate policy to keep the yen in a target zone, generally known to be a 5% band around the prevailing yen-dollar exchange rate. With the US dollar tending to decline in 1987 despite substantial forex intervention, the Bank of Japan accordingly kept interest rates low to try to weaken the yen to keep it in the target zone.
Indeed, the first increase in the official discount rate since late 1986, which the Bank of Japan had been urging for some time, finally took place on 30 May 1989. The “sanction” for this increase was provided by Japan’s ministry of finance only after a surge in the dollar in late May 1989 above 140 yen to the dollar, above its target range, thus removing the pressure on the Bank of Japan to keep the official discount rate and call money rate low so as to depreciate the yen. Raising rates much earlier would have most likely pricked the Nikkei bubble.
Also See From Bubble To Bust (Graphic)
Economic analysis put much of the blame for Japan’s collapse on its antiquated financial system, with excessive dependence on bank lending. During the good years ending in 1989, the Japanese banks’ capital base, which enabled them to make loans, had been founded on unrealized share capital gains. Some borrowers, in turn, had used the value of their land as collateral to bet on the stock market. Rising land and equity prices fed on each other.
However, when equity prices started to decline, it destroyed the economy by crippling the ability of the Japanese banks to make loans. The need for the commercial banks to maintain capital assets in accordance with new international norms, coupled with weak loan demand, made it impossible to revive the moribund economy.
Alan Greenspan has been a prominent proponent of the view that had Japan relied less on bank lending and more on deregulated securities and equity markets for financing activity, the slump would have been milder and the recovery stronger. This may well have been the case. By US standards, Japan’s banking and financial system was, and still is, “primitive”.
However, the more crucial lesson to draw is that Japan’s plight resulted from its lax monetary policy, and not due to its financial system. The exchange rate target was a weapon of its destruction. Continental Europe also relies heavily on bank lending, like Japan, and has stiff financial regulation. Unlike the US, loans are not then massively securitized. But the stringent policies of the German Bundesbank, and now the European Central Bank, keep financial and real cycles in check.
By the same token, we can also conclude that daily or hourly marking to market, full financial deregulation and extensive use of derivatives are no guarantee against a huge collapse, which has happened in the US. Derivatives are highly leveraged instruments, and leverage is inherently risky. While curbs on “weapons of mass destruction” can help prevent a major crisis, this may not be enough. Lax monetary policy led to more bank lending and leverage, and played a major role in Japan’s crisis.
Vivek Moorthy is an economics professor at IIM Bangalore. Comment at firstname.lastname@example.org